leveraged finance - All posts tagged leveraged finance

Fitch Ratings says that while the junk-bond market at times looks a bit frothy lately, we’re not yet a credit cycle peak, and Fitch “does not expect a significant breakdown in credit discipline among U.S. speculative grade issuers despite current high issuance volumes and historically low yields.” Fitch says this in its “Annual Manual” (it rhymes!) leveraged finance market primer, which aims to quantify major risk factors and opportunities in the leveraged finance sector.

Fitch says most current market trends, including defaults, pose little near-term risk to the high-yield market, with the exception of central bank policy and, interestingly, interest-rate risk, even though that’s been dormant so far this year:

Interest-rate volatility will play a much more prominent role in the fixed-income market in 2014 and dictate many portfolio decisions over the coming year. As seen during select periods of 2013, investors pulled large sums of money from the high-yield asset class, fearing the impact of higher interest rates on their portfolios. Demand for high yield bonds will likely be volatile in 2014, impacting issuance as future demand largely reflects investors’ expectations in defaults, economic growth, and interest rates risks. The impact of higher rates is expected to lower high-yield bond returns in 2014 to between 5% and 6%, from 7.4% in 2013.

Fitch examines where we are in the credit cycle given the extraordinary amount of Federal Reserve support (and distortion), and says things might look expensive but they’re not on the verge of falling apart:

The credit cycle is a key indicator of the relative ease of access to credit by leveraged borrowers. The credit cycle experiences alternating phases of contraction and expansion as the demand-supply balance swings from market dislocation to overheating and back. Fitch recognizes the currently high issuance volumes and historically low yields in the leveraged finance space. However, in the view of Fitch’s Corporates team, we do not see a great deal of breakdown in credit discipline despite diminishing returns.

Fitch sees a secular trend toward looser leveraged-loan covenants:

Recent trends seem to suggest that the broadly syndicated loan market has begun to shift to a more covenant-lite market, or one based on incurrence-based tests, similar to the high-yield bond market. In Fitch’s view, covenant-lite loans will continue to represent a growing portion of the broadly syndicated loan market over time

Fitch says other risk measures are on the rise but not near past peaks:

Deal volume has picked up, but overall deal size is smaller compared to the 2006-2007 LBO boom. Fitch believes the size, volume, and quality of LBO transactions are collectively less risky than the previous boom era vintage….

Leverage among high yield issuers has risen slightly. Issuer operating fundamentals modestly positive, offset by the moderate increases in debt. Management teams continue to show both discipline with respect to capex and cost containment, reflecting their cautious outlook on economic prospects….

Fitch notes the majority of the record level of high yield issuance continues to be used to take out maturing loans and to refinance bonds. This activity has generally been good for credit as it is solving the problems created in the last upswing.

Fitch Ratings takes a look at some of the risky practices that have seeped back into leveraged finance markets and says it doesn’t see signs of another leveraged buyout boom. Yet. From Fitch:

Concerns have arisen recently over whether elevated risk indicators present in the market today are similar to those present during the peak of the last credit cycle of 2006–2007. Fitch believes that key credit drivers today are more closely aligned with those the 2004 timeframe than those in 2006–2007. Fitch acknowledges that the overall risk appetite in the market has increased over the last two years driven by the record low yields, improved market liquidity, slowly improving economy, earnings growth and a benign default environment.

Fitch identified three key differentiating factors between today’s market and the peak of the last cycle: 1) new transaction quality, 2) use of proceeds and 3) current operating performance. Fitch also examined a number of secondary factors, which helped define the peak of the last credit cycle, including market and investor leverage, covenant-lite issuance, and leveraged buyout (LBO) issuance.

Fitch notes that leveraged lending has increased quickly over the last two years, reminiscent of the cycle peak of 2006-2007. Leveraged loan issuance has more than tripled from $239 billion in 2009 to $813 billion for the 12-month period ending April 30, while the high-yield bond issuance has increased from a low of $41 billion in 2008 to $314 billion in the 12-month period ending April 30. Despite this, Fitch says general risk-taking trends and deal structures are better factors in defining the overall risk in the market rather than absolute issuance totals.

We’re living in an era of cheap debt, and even people who used to shun high leverage levels are softening their stance. Namely, investors in initial public stock offerings, who once shied away from riskier, more deeply indebted companies that came to market with equity offering, aren’t as worried about these things at a time of record-low interest rates when seemingly every company and government is awash in more cheap debt. Telis Demos and Matt Jarzemsky report in the Wall Street Journal this morning that heavily indebted companies are going public at the fastest clip in years:

Satellite operator Intelsat SA (I), one of the most highly leveraged companies to come to market since 2009, sold $498 million worth of common and preferred shares on Wednesday. Other recent examples include aquatic theme-park operator SeaWorld Entertainment Inc. (SEAS), which saw strong investor demand and priced at the top of its pre-IPO price range on Thursday, and Pinnacle Foods Inc., (PF) maker of Log Cabin syrup and Vlasic pickles….

The trend marks another way in which the Federal Reserve’s easy monetary policy is filtering through the financial markets and changing investor behavior. In more normal interest-rate environments, high levels of debt often are seen as a negative by long-term stock investors because debt payments siphon away cash a company might otherwise use to grow.

Now, many indebted companies are readily getting stock-market funding, in part because debt payments are perceived as less onerous at a time of record low interest rates. In addition, as these companies take advantage of the IPO cash to pay down debts, some are able to offer the kinds of dividend yields that are attractive in an environment with record low interest rates on bonds.

Many of the companies in this story are familiar names in the world of leveraged finance, and had been owned by private equity firms, as Intelsat has been since 2005. That company had struggled previously under its debt burden but has been able to refinance debt at lower rates in recent years leading up to its IPO. The story says Intelsat has a leverage ratio of 7.6, with real-estate brokerage company Realogy Holdings Corp., (RLGY) which went public in October, the only other company that went public with a ratio greater than 7.

The story goes on to say that in all of these deals, the companies have said that proceeds will be used to pay down debts, not going to their private-equity owners, but some of the companies also intend to pay dividends to investors. The story also says the performance of these recent IPOS has been mixed, with Realogy up 71% from its October debut amid a housing rebound but Berry Plastics Group Inc. (BERY) up just 6.4% from its IPO pricing.

Now that we know the Times reads the Journal, we also learn that the Times reads itself. In its print edition Friday (while this blogger was too busy churning out his weekly Barron’s magazine column, which has also examined junk bonds recently, to take immediate notice), the Times curiously took a break from its timely coverage of Hurricane Sandy and the presidential election to publish its lead editorial on the subject of — junk bonds. The Times editorial cites the earlier Times story and its reporter, Nathaniel Popper, no less than three times, and essentially reads as just a lengthy recap of the story that concludes by adding in a call for more diligent federal regulation on behalf of investors:

It’s not enough to say that investors should educate themselves about the risks. It is the Federal Reserve’s policy of low rates that is pushing investors into riskier investments, so federal regulators have a duty to ensure that investors are not caught unaware, including through rigorous enforcement of rules against reckless, deceptive or abusive offerings.

The recent developments in junk bond investing also highlight, again, the dubious practices and privileges of private equity firms. One portfolio manager who buys junk bonds told Mr. Popper that he screened offerings to avoid those that “are going for no productive purpose.” Piling ever more debt on companies with dim prospects of repayment — in order to pay dividends to the private equity owners — would certainly qualify.

No one is predicting that today’s increasingly risky junk bonds will blow up anytime soon. But risky business, unchecked, has a way of doing so eventually.

If nothing else, this goes to show that the Times editorial board clearly deems this subject worthy of its (and its readers’) highest attention, even at a time when the paper has a host of other local and national issues on its plate.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.